Monday, November 14, 2011

Münchau to EU: Signal now that Eurobonds are forthcoming

Today, an eponymous Wolf Munch Rock award (so named because the truth is hard to swallow) to Wolfgang Münchau, for an op-ed that's at once a primer on the dynamics of the European sovereign debt crisis  and a powerful brief (judged on its own terms) for issuing Eurobonds sooner and working out the political implications later.

First, for the uninitiated, Münchau spells out why it's so destabilizing for the solvency of member states to come in doubt -- and why the haircut for banks holding Greek debt may have exacerbated rather than relieved the markets' panic:
I am hearing from Berlin that the German government believes that the arrival of Mario Monti as Italian prime minister is all it will take to calm the markets. This unsurprisingly complacent view misjudges the underlying dynamic of the most recent events. The cause of the panic attack was the European Council’s decision on October 26 to renegotiate the private sector participation of Greek sovereign debt holders. With that decision European leaders destroyed what was left of a functioning eurozone government bond market. Investors interpreted it – correctly in my view – as a precedent. They then dumped their Portuguese, Spanish, Italian and even French government bonds. As of now, there is only one significant risk-free asset in the eurozone – German government bonds.
The German government bond market is large and liquid, but not large enough to sustain the world’s second largest economy. The presence of a risk-free asset can hardly be overstated in a modern financial system. Each insurance company, each pension fund needs to invest part of its income in such assets. Through a combination of short-sightedness and financial illiteracy, the European Council has now put itself in a position where it desperately needs Eurobonds, if only to assure the existence of a functioning financial sector.
Next, why the European Financial Stability Facility (EFSF) is inadequate:

The second reason you need a Eurobond is the effective collapse of the silly idea of leveraging the EFSF. Klaus Regling, the EFSF’s head, is wrong to say that market volatility has made it impossible to reach the leverage target. It was the other way round. The eurozone’s refusal to capitalise the EFSF properly contributed to the panic. A leveraged EFSF would have the worst kind of Eurobond: a tranche in a toxic debt security. I really hope EU leaders will come to their senses and stop pussyfooting with dubious financial instruments. The eurozone needs a risk-free asset class, and this means something boring and simple.
Recently, Münchau's colleague (and fellow eponymous Wolf Munch Rock laureate) Gideon Rachman argued compellingly that the Eurozone can't be fixed without a political solution that will not come fast enough:
On the political side, the long-term fix to the euro’s malaise is said to be a fiscal union, a true political federation. But this is a solution that will take decades to implement, for a crisis that is escalating by the week. The final destination is, in any case, inherently implausible, given the lack of pan-European solidarity revealed by the current mess.
Münchau today is pleading to reverse that sequence:
The introduction of a Eurobond will, in turn, require a broader and deeper economic government that extends well beyond the notion of a fiscal union. It would be more than a financial instrument. If it were to happen, it would catalyse further political integration.
But he's almost as dubious as Rachman that either of the two necessary events, moving on such irreducibly different timelines, is likely:
But it might not happen. The crisis is moving too fast. We may well find that the Germans, the Dutch and the Finns are not ready for this. Their political leaders have certainly not prepared the ground for such a momentous decision. When the decision day comes, the day when the crisis reaches its bifurcation point, they might not be ready.

Reinforcing that "might not," today the president of the Bundesbank, Jens Weidmann, "firmly rebuffed international demands for decisive intervention in the bond markets by the European Central Bank to combat the eurozone debt crisis, warning that such steps would add to instability by violating European law." [Update, 11/16: Apparently, though, the ECB can legally buy sovereign debt in the secondary market; Brad Plumer cites experts asserting that doing so would suffice.

Addressing longer-term legal issues, Münchau lays out a sequence of action:
Of course, the EU cannot introduce a Eurobond overnight. The most its leaders can do is to issue a credible statement of intent, and set in motion a process to enact the legal changes needed. It will take time.

But once they make such a declaration, there should be no obstacle to endowing the EFSF with a banking licence. The EFSF could announce that it would make unlimited purchases of national sovereign bonds to keep their spreads under an agreed cap – say 2 per cent for 10-year bonds. The European Central Bank would refinance the EFSF for as long as it takes. Once the Eurobonds are in place, EFSF liabilities would simply be transformed into Eurobonds. This would not constitute an illegal monetisation of debt, as long as the endgame for the EFSF is credible.

For a reader (me) who's neither an economist nor European, it's been horrifically fascinating to watch the slow-motion European train wreck unfold inch by inch on the FT Comment page, courtesy in large part of the Wolf-Munch-Rock [Rach] trio: Münchau warning, as each incremental action unfolds, that it is inadequate; Rachman highlighting the lack of political will for the fiscal union that a single currency requires; and Martin Wolf repeatedly spotlighting the foolishness of prescribing harsh austerity for contracting or flatlined economies.

1 comment:

  1. Events keep accelerating. An amateur's guess, but I would bet on more steps towards integration. Guess it might be time to reassess the judgments on Merkel's and Sarkozy's "leadership" in forcing the banks to take the haircut, trading short term political benefit for a deepening of the crisis.